As an IT contractor, two common ways to provide your IT services to clients are either through a limited company or an umbrella company – and each mode of operation will determine your tax obligations.
The UK business landscape is mostly made up of SMEs ranging from micro (0-9 employees), small (10-49 employees) to medium-sized (50-249 employees) companies. The nature of SMEs makes getting external IT contractors a viable option for companies that lack the internal resources to fulfil their IT functions, particularly in this day and age when the rate of technological advancement can be startling, making it hard for non-experts to keep up.
Common IT services engaged by SMEs include network set-up, software support, database management, cloud storage and computer repair, to name but a few. In the UK, particularly in London, there are hundreds of thousands of IT contractors assisting businesses with various IT issues.
Most IT contractors choose to operate through an intermediary such as a ‘personal service company’ in the form of a limited company. The reason is simple – incorporating your IT contractor business as a limited company is tax efficient as it allows you to:
- Split your income between salary and dividends. Dividends aren’t subject to National Insurance Contributions (NICs) and also taxed at a lower rate, meaning you pay less tax.
- Claim tax relief on legitimate expenses
Tax obligations for IT contractors operating through a limited company
For IT contractors operating through a limited company, your main tax obligations are National Insurance Contributions (NICs), Dividend tax, Corporate tax, VAT and income tax. It is, however, best to take advantage of our free initial consultation and discuss your tax obligations with one of our specialist accountants for contractors face-to-face.
National Insurance Contributions (NICs)
National Insurance is a tax system that funds state benefits. At present, if you draw a salary of more than £166 to £962 a week, you are required to pay 12% Class 1 National Insurance rate. For a salary above £962 a week, you pay a 2% charge on the additional earnings.
Most contractors pay themselves by drawing a salary and also declaring dividends. While dividends aren’t subject to National Insurance Contributions, drawing a salary above £166 a week will see you make a contribution to National Insurance as stated above.
There are contractors who consciously pay themselves less than £166 a week to minimise their exposure to NICs. They then take dividends from retained profit to form the majority of their income. It is best to talk to an independent accountant and work out your annual salary if you plan to take this approach.
After a company pays its Corporate tax, the retained profit can be distributed as dividends to shareholders (which generally means you, as you are likely to be the sole shareholder of your limited company).
Thanks to its three main benefits, many contractors choose to use dividends to form part of their income. The benefits are:
- Dividends are not subject to NICs.
- A £2,000 dividend allowance is provided, meaning the first £2,000 of dividends aren’t taxable.
- Dividends have a lower tax rate than salaries. For tax year 2019/20, dividend tax rates are 7.5%, 32.5% and 38.1% which you must declare on your self-assessment.
You pay dividends by declaring them in the company board meeting minutes and writing up a dividend voucher showing the date, company name, name(s) of the shareholder(s) being paid a dividend and amount of the dividend.
Corporation tax is a levy paid on a company’s profits; the figure of which emerges once legitimate business expenses have been deducted from revenue. As mentioned in the article “Business expenses you can claim as an IT contractor”, if you’re a contractor operating outside of IR35, you can claim more business expenses than a contractor in IR35 and the article lists quite a few examples. In the event that you are still unsure about IR35, it’s best to talk to one of our accountants specialising in contractors or check out this post “What is IR35? A brief guide to the IR35 legislation”.
For tax year 2019/20, Corporate tax rate is at 19%, but the government plans to reduce the rate to 17% for tax year 2020/21. The Corporate tax year spans from 1 April to 31 March annually which may or may not be aligned with your company’s accounting period, and in general, you have 12 months from the end of your accounting period to file your return and 9 months to pay any tax due – deadlines are imperative so most contractors rely on a qualified accountant to handle this.
Value Added Tax (VAT)
It is commonplace for contractor businesses to be registered for Value Added Tax (VAT), which is applied to all services you provide to clients. You will be required to submit a quarterly VAT return to HMRC alongside an electronic payment for this sum.
The standard rate for VAT charged to clients is 20% of the service fee, however, you can apply to HMRC for the VAT Flat Rate Scheme, which can be beneficial to your business (depending on its structure and setup) in circumstances where you negotiate a reduced fixed rate of VAT and can keep the difference between what you pay and what you charge your customers.
Current VAT flat rates that can be applicable to an IT contractor and save them money are:
- Computer repair services 10.5%
- Computer and IT consultancy or data processing 14.5%
To join the scheme, your VAT turnover must be less than £150,000 (excluding VAT) a year.
In the UK, if you’re self-employed, a business partner or a director of a limited company, you’re required to file a tax return. You must submit your self-assessment tax returns by 31 October (paper) or 31 January (online), otherwise, you risk being penalised as discussed in our post “Self-Assessment Penalty: What happens if you miss the Self-Assessment Tax Return Deadline?”
As an IT contractor juggling multiple tasks, our advice to you is to use an accountant with proven track records working with contractors to help you manage your tax affairs.
Umbrella Company Tax
For IT contractors who work under an umbrella company, you’re considered as an employee in the umbrella company, meaning the company deducts all taxes and NICs and you receive a net salary have no further taxes to pay. Although it sounds easy, in reality, you are likely to pay more as the monthly fee charged by the umbrella company can be substantial.
Experienced accountants for IT contractors
To speak with one of our professional accountants for contractors to discuss more tax planning tips for IT contractors operating as a limited company in London, contact us today on 020 8108 0090 or get in touch with us via our contact page to arrange a complimentary, no obligation meeting.
If you found this interesting and informative, you should check out:
- Tax planning tips for self-employed contractors
- Moving from permanent employee to full-time contractor
- How Xero can help contractors in the UK
This post is intended to provide information of general interest about current business/ accounting issues. It should not replace professional advice tailored to your specific circumstances.